In part 1 of this series, we discussed RSUs and non-qualified stock options. In this article, we’ll look at incentive stock options and employee stock purchase plans, both of which tend to be more complex when it comes to the tax implications and planning considerations.

Incentive Stock Options (ISOs)

How they work

Incentive stock options work very much like NQSOs – they come with a vesting period, exercise price, and expiration date.

There are some limits on the value of incentive stock options that can be granted each year, but the real difference between ISOs and NQSOs comes in how they are taxed.

How they are taxed

ISOs are not taxed when you exercise the options, but instead are taxed when you sell the shares.

This means that there is no tax withholding when you exercise these options. However, depending on the size of the spread (the difference in the market value of the shares when you exercise and your strike price) you may have to pay alternative minimum tax in the year that you exercise the shares.

Once you sell the shares, the tax rate that you pay on any gains (the difference between the strike price and the price you sell the shares for) depends on how much time has passed since you were granted the options and since the date you exercised them.

If you sell the shares more than 2 years after the grand date and 1 year after the date you exercised the options, any difference between the strike price and the price you sell the shares for is treated as a long term capital gain.

If you don’t meet the 2 years from grant date and 1 year holding period criteria, then the difference between the strike price and the fair market value of the shares on the date that you exercised the options is taxed as ordinary income. Any additional increase in the value of the shares after the date you exercised is considered a short term capital gain (typically taxed at the same rate as ordinary income, but can be offset by capital losses, if you have any).

Planning considerations

ISOs offer what can be significant tax benefits when you exercise and hold the options. However, this strategy comes with significant risk. 

The value of the shares you receive after exercising is not guaranteed to increase or even stay flat. So you have to weigh the benefits of a lower tax rate when you eventually sell against the risk that the shares will lose value and wipe out any gains you initially had.

Your personal tax situation plays a big role in making this decision – for some people the difference in ordinary income tax rates and capital gains tax rates can be large. And for others that difference may not be as big. 

You should also consider how important the money is to your long-term financial plan. Can you risk losing some of the value, or are these funds a critical part of your plan that you can’t afford to lose?

If you work for a private company, the potential tax benefits that come with ISOs provide some incentive to exercise options sooner rather than later if you expect the company to grow. However, as with NQSOs, you have to weigh the risk that you won’t be able to realize any gains if your company does not go public or provide another opportunity to sell your shares.

Employee Stock Purchase Plans (ESPPs)

How they work

Employee stock purchase plans allow you to buy shares of your company’s stock at up to a 15% discount.

Your employer will define an offering period of typically one to two years, and within that offering period, there will be several purchase periods. So for example, there may be a one year offering period with two 6 month purchase periods.

Each purchase period, you decide how much to have withheld from your paycheck and set aside to buy your company’s stock. There may be limits set by your company on the percentage of salary you can have withheld, and there is a $25,000 annual limit which is set by the IRS.

At the end of the purchase period, your paycheck withholdings are used to purchase shares of your company’s stock. The 15% discount is applied to the current market value of your company’s stock, or (if the plan has a lookback feature) the lower of the price at the beginning of the offering period or the current market value. 

Once the shares are purchased, you have access to either sell the shares or hold on to them.

How they are taxed

Shares purchased through an ESPP are not taxed until sold.

If you sell the shares within two years of the beginning of the offering period or within one year of acquiring the shares, you pay ordinary income taxes on the discount (the difference between the market value of the shares on the date they were purchased and the price you actually paid) and short term capital gains on the change in value between when you acquired the shares and when you sold them.

When selling the shares after meeting both the two years since the beginning of the offering period and one year since acquiring the shares criteria, you still pay ordinary income tax on a portion of the gain, but the ordinary income tax is potentially calculated in a more beneficial way.

This video walks through examples of the different tax outcomes in each of these scenarios.

Planning considerations

Once you decide to participate in your employer’s ESPP, you then need to start thinking about whether you want to sell the shares immediately after purchasing or if you want to hold onto the shares and potentially realize the tax benefits of doing so.

As with other forms of equity compensation, you need to weigh the investment risk, or the risk that the shares lose value between when you purchase them and when you ultimately sell against the tax benefits of holding the shares.

Final thoughts on Equity Compensation

Equity compensation can be a significant benefit, but you need to make sure you don’t end up holding shares of your company’s stock without a plan in place.

Be careful not to take more investment risk than you can afford, think about diversifying your human and financial capital, and be sure you understand the tax implications.
But most importantly, have a plan for how you’re going to use your stock compensation to make progress toward your family’s unique goals. And if you need help thinking through how to go about this, reach out to us!

Joe Calvetti is a CPA and the founder of Still River Financial Planning, a comprehensive, fee-only financial planning firm that specializes in working with young families and professionals. Click here to learn more about how we work with clients.

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Disclaimer: The information provided above is for educational purposes only and should not be considered financial, legal, or tax advice. You should consult with a professional for advice specific to your situation.